Fed says pandemic has created U.S. financial sector fragility that will last for some time

The Fed

Published: May 16, 2020 at 9:25 a.m. ET

Financial institutions, including banks, could experience strains

Regulators are urging banks to give their customers loans to help them weather the coronavirus national emergency.

FREDERIC J. BROWN/AFP/GettyImages

The coronavirus pandemic has created a fragile U.S. financial system that could last “some time,” the Federal Reserve said Friday.

“The strains on households and business balance sheets from the economic and financial shocks since March will likely create fragilities that last for some time,” the central bank said in its latest semi-annual report on the financial sector.

As a result, banks and other financial institutions “may experience strains as a result.”

Fed officials said how long those circumstances would last depended on the speed of the economic recovery.

Fed Chairman Jerome Powell said earlier this week that a lengthy downturn could turn liquidity problems into solvency issues.

The Fed has set up over $2 trillion in lending programs designed to ease stressed conditions in all corners of the financial markets.

There is a risk from asset pricesSPX,+0.39% if the pandemic were to take an unexpected course, the report said.

Businesses have a weakened ability to repay debt obligations that were at historic highs right before the pandemic hit the economy.

“Forceful early interventions have been effective in resolving liquidity stresses but we will be monitoring closely for solvency stresses among highly leveraged business borrowers, and we could increase them the longer the Covid pandemic persists,” said Fed Governor Lael Brainard.

The study found that broker-dealers struggled to provide intermediation services during the acute phase of the financial crisis in March. In contrast, banks have been able to meet surging demand for draws on credit lines.

Some hedge funds may have been severely affected by the large asset-price declines and increased volatility in February and March, the Fed said.

The capitalization of the life Insurance sector is likely to deteriorate in coming quarters, the report said, because of lower-than-expected asset valuations and lower long-term interest rates. Insurance companies are also important investors in commercial real estate, corporate bonds and securities products known as collateralized loan obligations, or CLOs. This exposes the sector to several risks including rising defaults in the corporate sector.

CLOs don’t generally permit early redemptions and so avoid run risk, but face pressure if there are downgrades of CLO tranches. Some hedge funds purchase lower-rate tranches using leverage, the report said.

All in all, “the prospect for losses at financial institutions to create pressures over the medium term appears elevated.

See also: Latest on Fed’s expansive rescue programs to keep credit flowing during the coronavirus pandemic